Edited by James R. Barth, Chen Lin and Clas Wihlborg
Chapter 13: Market Discipline for Financial Institutions and Markets for Information
Apanard P. Prabha, Clas Wihlborg and Thomas D. Willett 13.1 INTRODUCTION Under ideal conditions competitive markets should induce firms to adopt good governance procedures that lead to the maximization of shareholder value. Firms that do not approximate such behavior will face penalties in the form of lower profitability and higher costs of financing. Ultimately the wayward firms will be forced out of business or at least shrink or be taken over. Ideally market discipline would begin to come into play as soon as a firm begins to go astray, and markets would provide early warning signals and incentives in sufficient time for management to take corrective actions well before bankruptcy or financial market disruptions occur. The recent global financial crisis has again shown that once concern arises in the markets they place enormous pressure on public as well as private sector entities. As we will document in sections 13.4 and 13.5, however, financial markets generally failed in the run-up to the crisis in terms of giving strong warning signals in a timely enough fashion for disaster to be avoided. A major purpose of this chapter is to analyze why such early warning signals were not forthcoming and consider what, if anything, can be done to help induce financial markets to provide early warning signals that provide corrective discipline in advance of the generation of crisis conditions. We also consider theoretical arguments and empirical evidence on whether some types of financial instruments have tended to be better than others at providing...
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